Yesterday a senior official from the United States Treasury addressed a big crowd in Hong Kong at a luncheon organised by the Asia Society. He talked about the thinking at the Treasury during the credit crisis but, inevitably, the interesting part was the Q&A.

Foremost on peopleÆs minds was why the US government organised the sale of Bear Stearns to JPMorgan Chase in March, only to let Lehman Brothers go bankrupt in September, the impact of which has badly damaged global capital markets and investors.

McCormick says at that stage, the US government was dealing with crises on a case-by-case basis. ôHopefully weÆre now out of the case-by-case business,ö he says, remarking on the governmentÆs more strategic approach to rescuing the banking system. Each decision required a balance between systemic risk and imposing discipline on the markets. In the case of Lehman, he says that, unlike with Bear Stearns, there had been open speculation about its fate for months. ôWe had hoped this would have reduced the risk,ö he says.

Secondly, there was no buyer for Lehman Brothers, he says, unlike the case with Bear Stearns. Of course, in BearÆs case, the Federal Reserve was willing and able to put its balance sheet behind its toxic assets, to the tune of nearly $30 billion. McCormick says this wasnÆt possible in LehmanÆs case because its balance sheet was so much bigger. Moreover, while now the US Treasury has powers under the $700 billion bailout package to take equity stakes in financial service providers, it did not in early September. He says that, if Lehman had gone under today, once the Treasury had been given added powers by Congress, ôit would be a different situationö.

On efforts to regulate credit default swaps, McCormick says the market needs to become more transparent. The Federal Reserve is taking the lead on this. Furthermore, he says the Treasury believes the business models of credit rating agencies must change when it comes to how they rate structured products. He says the government is considering various proposals, but offered no details.

When asked ôis the Chicago School of economic thought deadö, he acknowledged the unusual fact of a free-market Republican administration asking Congress for state intervention into the banking system. He says this was the least bad alternative, compared to a total systemic meltdown and the terrible cost this would put on the economy. ôWe must ensure we get out of the business of owning banks as rapidly as possible,ö he says, noting the nine banks in which the US government has taken equity minority stakes have been given incentives to divest those stakes over the next five years.

From this followed a question about the governmentÆs equity stakes in major investment banks, and whether this was repeating the errors with Fannie Mae and Freddie Mac, in which quasi-government organisations were given a competitive advantage in the marketplace because of their access to cheap funding.

McCormack first says that Henry Paulson, the Treasury secretary, warned the government-backed enterprisesÆ business models were flawed more than a year ago, but his warning went ignored. More to the point, McCormack says the government equity stakes are meant to create a ôtime outö period to stabilise the markets, and set the conditions for proper reforms. ôWe realise now that the Fannie Mae and Freddie Mac business model of profit maximisation combined with a public mission is not sustainable,ö he says.

This understanding has influenced the terms of the governmentÆs nationalisation of Freddie and Fannie. They are required, starting at the end of 2009, to begin winding down their portfolios by 15% per annum, and they must now pay a fee for the governmentÆs guarantee on any new debt.

ôThe next administration must determine the right structure,ö he says of the mortgage agencies. That could mean outright nationalisation, full privatisation, or a hybrid, but not a return to the old model.

One question concerned whether the US government believes it has any moral authority to pressure other countries to adopt open market, pricing-based economic systems.

ôItÆs certainly a humbling time,ö McCormack began, who says the government acknowledges the important role that US financial innovation has played in the credit crisis. He says the US is trying to address the core problems and take the lead in helping stabilise markets, with a view to ensuring America emerges even more competitive. Out of this will emerge a new generation of bankers who will spend the next several years trying to figure out the best business model to fit the times.

Next, he said the US has tightened its communication and coordination with China, and was busy sharing the lessons it has gleaned from the crisis, to help China avoid similar mistakes. But McCormack drew a line between financial innovation that led to the crisis, versus the merits of a liberalised, open market, in which competition reigns. ôDonÆt learn the wrong lessons,ö he says.

Pursuant to this theme, a question asked what the US was doing to reform the World Bank, the International Monetary Fund and other multilateral organisations to give emerging markets such as China a seat at the table.

McCormack pointedly noted that the United States for several years has openly campaigned to see China, India, Brazil and others elevated to equal leading roles at these organisations. ôItÆs other countries that would lose their share of a voice, that have opposed reform. WeÆll continue to ask these organisations whether their mandates need to change.ö

Lastly, what happens in January when, regardless of who wins the US Presidential race, the top 25 people at the US Treasury will change, as a new team comes in?

McCormack notes that the timing is unfortunate, but he hopes the outgoing and incoming teams are able to have well defined goals, which is necessary to boost confidence and maintain the momentum of reform. He notes that Paulson has been in regular touch with both the Obama and McCain camps. There should not be any change in direction, but there is an execution risk, he says.

Looking to next year, McCormack says the big policy risk is protectionism, in the US as well as in China and many other countries. There is a tendency in times of stress for societies to turn inward, but this would be a tragic error. ôThe worst thing we could do is to slow the key injection of life into our economy û the free flow of capital and of goods. But we canÆt take openness for granted.ö